Intermediated Securities
1. Subject matter and purpose
The safekeeping and administration of securities or financial instruments by custodian banks has developed into an area to be distinguished from the rules of general deposit, ie the business of custody of investments or global custody. In the broader sense the law of global custody deals with the legal characterization and regulation of those operational infrastructures which have emerged on modern financial markets to allow for a smooth processing and settlement of securities transactions as well as an effective administration of the underlying assets (see 2. below). Systematically, the law of intermediated securities thus forms part of banking law as well as of securities capital markets law and aims in particular at investor protection.
2. Modern financial market infrastructure
a) Immobilization of securities
Today, acquisitions and dispositions of securities traded on capital markets (financial instruments) are, from an operational perspective, effected only via credits and debits in securities accounts maintained by custodians. This development was initially based on the so-called immobilization or mediation of securities: any (bearer) security certificate issued within a country is immediately transferred to a central securities depository (CSD) that undertakes the permanent safe custody of the whole issue. If registered securities are immobilized, either the CSD or its nominee is entered into the relevant register instead of the final investor. Hence, the register does not need to be changed to reflect trading (but, if applicable, for the purpose of legitimization vis-à-vis the issuer). Within this ‘mediated’ or ‘indirect holding system’, the certificate or register entry that represents the underlying asset no longer points directly to the investor having the economic interest therein. The CSD does not hold the shares on its own behalf but rather on behalf of its customers, usually a limited number of custodians (participants). The CSD maintains securities accounts on which it breaks down which type of financial instrument it retains in what amount for which participant (first or highest holding tier). The participants, in turn, partly hold these shares as their own stock (proprietary securities) but predominantly on behalf of their own customers (customer securities) as evidenced by entries in the securities accounts operated by the participants as custodians (second holding tier). Further tiers may follow before the final investor is reached. Thus, a safekeeping pyramid comprising a holding chain of any number of custodians is created. Each link in the chain maintaining customer accounts qualifies as an intermediary. Similarly to the modern giro payment system, dispositions are accomplished solely by credits and debits on securities accounts managed by intermediaries on the investors’ instructions; no physical transfer takes place (‘book-entry securities’, Art 2(2)(g) Dir 47/2002 of 6 June 2002 on financial collateral arrangements). Hence, physical certificates have lost their original function almost completely; even the exercise of the rights attached to the securities (eg dividend and interest payments, preemption and voting rights, or other corporate actions) is normally processed through intermediaries (see Dir 36/2007 of 11 July 2007 on the exercise of certain rights of shareholders in listed companies).
b) Transparent and non-transparent holding structures
Within the mediated holding system, contractual relationships (account agreements) exist only between the respective neighbours in the custodial chain. Intermediaries usually maintain fungible or omnibus accounts, ie they pool the securities of one customer and credit them to the customer’s account on an unseparated basis even if the latter holds the assets for downstream customers (dépôt en fongibilité, verzameldepot, Sammelverwahrung). Therefore, end-investors are unknown at higher tiers; they may only be identified by looking into the books of their immediate intermediary. This phenomenon is called a non-transparent holding structure (eg Austria, Belgium, Germany, France, Netherlands, Switzerland, Canada, the United States, and optionally in England). However, there are also transparent holding systems in which credits may at all tiers be directly assigned to the respective end-investor (eg Greece, Nordic countries, Spain, optional in England). To this end, some systems allow even private investors to become members of the CSD, which then manages an unlimited quantity of individual accounts (single-tier holding, eg Greece, optional in England). In other systems the accounts of the CSD participants consist of various sub-accounts showing the final investors (two-tier holding, eg Finland, Spain, optional in Sweden). Hence, in these systems the true shareholder may be identified by one glance into the books of the CSD.
c) Dematerialization of securities
The obvious discrepancy between the costs of the producing and safekeeping of paper certificates and the practical significance thereof led to a phenomenon closely related to that of immobilization: the dematerialization of securities, ie the partial or complete abandonment of physical certificates as a means of representation of underlying assets. The first step was the aggregated securitization of identical shares in one or more ‘global’ or ‘jumbo’ certificate (eg Austria, England, Germany, Luxembourg, the Netherlands, Switzerland, Canada, the United States). Often, the entire issue is permanently represented by only a single global certificate. By virtue of a legal fiction this single document represents a number of individual certificates equivalent to the face value of the issue, but the shareholders’ right to ask for individual certificates has been fully excluded in the terms of the issue. Hence, even though ‘true’ certificates theoretically still exist, trades may only be settled electronically through credit/debit transfers instead of any physical delivery. It thus appears more consistent to abandon any paper basis in total and to install an electronic registry system involving ‘dematerialized’ or ‘uncertificated securities’ instead. In the 1980s, France was the first legal system to convert its securities system for all financial instruments of all issuers into a pure book-entry system based on dematerialized securities; an example which is being followed by an increasing number of countries (eg Belgium, Greece, Italy, Spain, Nordic countries, Japan; optionally (and partly established even earlier) in England, Switzerland, Australia, Canada, the United States; limited to government bonds in Austria, Germany).
d) Clearing and settlement of securities transactions
The subsequent operational processes following the conclusion of a securities trade via a securities exchange (exchanges) or other markets for financial instruments (trading) and serving the clearance and performance of the transaction are usually referred to as the post-trade phase or the clearing and settlement (C&S) of the transaction. The term ‘clearing’ generically and comprehensively paraphrases all steps necessary to determine the mutual obligations and to prepare the fulfilment thereof, ie transmission and reconciliation of trade details, bilateral set-off of similar obligations, assessment of collateralization duties, etc. Often, a central counterparty (CCP, Art 2(c) Dir 26/1998 of 19 May 1998 on settlement finality in payment and securities settlement systems) is involved in the process of clearing. If so, each trade between the market participants is split into two identical contracts with the CCP as a respective counterparty (trade A-B becomes trade A-CCP and CCP-B). The CCP thus assumes the credit and settlement risk of the participants which are obliged to provide sufficient financial collateral to mitigate the risks involved (margining). As far as they relate to the same type of security, the various contractual obligations between the participants and the CCP are set-off to a single net delivery obligation (‘peak’) (multilateral netting). Thus, the volume of securities which effectively have to be moved and the associated risks are substantially reduced (by over 90 per cent). The final step consists of the actual delivery of the securities by way of debit/credit transfer, ie the settlement of the trades. At the top tier of the holding chain the CSD performs the necessary book entries (securities settlement system, SSS) while the intermediaries are responsible for the corresponding bookings at the downstream levels. If a CCP is used, only the net peaks will be cleared within the SSS. On lower tiers, however, all trades have to be evidenced by book-entries. That is why, today, it is usually impossible to identify a complete chain of debits and credits connecting seller and buyer in case of transactions on a securities exchange. Within the book-entry securities system the (intermediated) access to a settlement system is a prerequisite for participation in securities markets (essential facility). Therefore, the respective infrastructures are becoming more and more interlinked even in the cross-border context. In addition, there are two specialized institutions in Belgium and Luxembourg serving as settlement hubs for international securities transactions (international central securities depositories, ICSD).
3. National regulatory structures
The situation of assets of different proprietors being lodged with a depositary which transfers them to a third party not separating and allocating them to the original depositors (fungible custody) usually gives rise to a depositum irregulare, ie the proprietors lose their right in rem in return for a mere contractual claim (deposit). Hence, investors would be exposed to their intermediaries’ insolvency risk and would thus be worse off than under traditional securities law. Therefore, the shielding of the investment from the custodian’s credit and custody risk constitutes a central purpose of the rules relating to intermediated securities. In addition, the traditional securities law with its physical connecting factor for the disposition of equity interests meets its constructive limits on modern capital markets. Conceptual problems are raised, for example, by issues of good faith acquisition (acquisition of ownership from a non-owner) or the concept of tracing of assets within the book-entry system. Many issues still remain to be clarified in several national legal systems. From a comparative perspective, two main (but overlapping) approaches may be identified, ie the co-ownership solutions and the trust solutions.
a) Co-ownership solutions
In Europe, most continental legal systems grant the investor a right in rem in all securities deposited with the CSD or registered in its name in the form of joint or co-ownership. They thus construe a direct link in rem between the final investor and the physical certificate or register entry which represents the respective underlying asset. However, investors have no property right to individually identifiable papers or register entries but rather a fractional co-ownership right in all assets of the same type deposited at the CSD (German (1937) and Austrian (1969) Depotgesetz). Other legal systems employ a legal fiction according to which all securities credited to accounts within the intermediated holding system form part of a (virtual) global safe custody deposit irrespective of their actual place of safekeeping (universalité de titre de même espèce). The investor receives a ‘non-physical right of co-ownership’ in this virtual deposit (droit de copropriété, de nature incorporelle, Belgian Arrêté Royal n°62 (1967); similarly, Luxembourg Loi du 1.8.2001 (formerly Règlement Grand-Ducal du 17.2.1971), Dutch Wet giraal effectenverkeer (1977/2011)). Outside of the account provider’s insolvency, however, the investor may not exercise this right in rem erga omnes but only vis-à-vis its own intermediary (Belgium, Luxembourg, Netherlands; the correct interpretation is disputed in Austria, Germany). Even the paper-free French system sticks to a ‘physical’ terminology in describing the investor as being the owner of book-entry securities ‘materialized by account credit’ (valeurs mobilières ne sont matérialisés que par une inscription au compte de leur propriétaire, Art R211-1 Code monétaire et financier). Italian law expressly states that the holding of securities through fungible accounts shall be regarded as a depositum regulare (depositors keep their original right in rem) and that a debit/credit transfer qualifies as physical delivery (Legge 19.6.1986, n. 289). Finally, transparent systems always grant the investor a direct property right to the shares evidenced on the accounts of the CSD.
As to the disposition of these rights in rem, some legal systems simply apply the general rules of transfer of title (movable goods) whereby the debits and credits are interpreted as the transfer of constructive possession of the underlying certificates (Austria, Germany). Other laws contain an explicit reference to the account bookings as the transfer mode (virement de compte à compte, Belgium, France, Italy, Luxembourg, Netherlands). In many legal systems, however, the precise scope of these principles still remains to be clarified. With a view to the principles of good faith acquisition, for example, it is often disputed whether account credits substitute for the transfer of physical possession (acquisition of ownership from a non-owner). The prevailing view in Germany and Austria answers this question in the affirmative. Just recently (2009), the French legislature ordered that the general principle la possession vaut titre of Art 2279 Code civil shall apply to ‘possession of credits’ as well; the same was done earlier in Belgium. According to Italian law, the same effects should be ascribed to a credit/debit transfer as to the physical circulation of paper securities. Overall, as far as dispositions are concerned, the co-ownership solutions treat the mediated and to a large extent dematerialized book-entry securities more or less analogously to traditional securities law. This view is still based on the idea that, in commercial transactions, the very same asset is transferred (viz the share of co-ownership in the collective safe custody) irrespective of the question whether transferor and transferee can be identified ex ante or ex post, and whether they are actually linked to each other by a continuous chain of debits and credits.
b) Trust solutions
According to the trust solutions, the investor has no direct right in rem to the assets kept by the CSD. Rather, the investor receives a direct property right only to the assets held with its own intermediary. The leading model in this respect is the ‘security entitlement’ under Art 8 of the Uniform Commercial Code (UCC) in its revised version of 1994 (this concept has also been adopted in Canada, Panama, Puerto Rico). A security entitlement is defined as a package of rights of the account holder against its intermediary comprising of, inter alia, the right to dispose of the book-entries and the intermediary’s duty to enable the investor to enjoy the rights attached to the underlying securities. Hence, in principle, a security entitlement qualifies as a (mere) contractual claim. It is, however, vested with important proprietary (erga omnes) effects. Namely, all credits granted to the intermediary by its higher tier custodian are shielded from any recourse by the intermediary’s general creditors and serve only to cover the account holders’ claims. Thus, a property right sui generis between the law of obligations and property law emerges. Despite some ambiguities, the prevailing opinion interprets the unwritten English law as being substantially in line with the concept of security entitlement. The fungible holding of securities through intermediaries is understood to constitute a chain of successive trusts, each in favour of the respective downstream account holder. The assets of the (sub-)trust in favour of the final investors consist of the equitable interest (equity) enjoyed by the custodians in the assets held by their own intermediaries. The participants of the SSS are the legal owners of the underlying securities which hold their legal title on trust for downstream customers. Further, a similar trust solution is implemented by some continental legal systems for securities stored abroad but credited to domestic securities accounts (eg Austria, Germany; others simply apply their local regime for intermediated securities, eg Belgium, Luxembourg, Netherlands). The Swiss Bucheffektengesetz of 2008 combines the co-ownership model with the concept of security entitlement and creates an own asset falling between those two solutions (similarly already in Belgium, Luxembourg, the Netherlands).
Dispositions in the trust system are construed analogously to the giro transfer model implemented in payment systems: each credit gives rise to a new asset in the hands of the transferee while the transferor’s asset extinguishes once the account is debited. Thus, there is no ‘passing through’ of the same asset along the holding chain. Therefore, in principle, this model does not give rise to any problems of good faith. In addition, the practice of multilateral netting resulting in the de facto impossibility to trace assets does not cause any conceptual difficulties. However, the trust system theoretically allows more book-entries to be credited to end-investors than shares have originally been issued, which may lead to problems in the context of corporate actions.
4. Regulatory structures of Union law
As to Union law, the Finality Directive (Dir 26/1998) and the Financial Collateral Directive (Dir 47/2002) constitute the basic cornerstones of the European market infrastructure regime (financial collateral). In addition, the Directive on Markets for Financial Instruments (MiFID) (Dir 39/2004) including implementing directive (Dir 73/2006) contain provisions relating to the safekeeping of the mediated assets (Art 13(7) MiFID, Arts 16 ff Dir 73/2006). Furthermore, the MiFID grants market participants a claim to (cross-border) access to and the choice of C&S systems (Arts 34, 46). As a result a given market is not necessarily linked to a single predefined settlement system. Rather, a trade may be concluded in country A, cleared in country B and finally settled in country C provided that the respective systems are compatible and interlinked. The latter can only be realized by the service providers themselves. For that reason (and to counter concerns of competition law), the C&S industry elaborated a code of conduct (private rule-making and codes of conduct) with rules on price transparency and system compatibility. Its implementation is supervised by the ‘Monitoring Group of the Code of Conduct on Clearing and Settlement’ (MOG) installed by the European Commission.
Issues relating to intermediated securities are increasingly coming into the regulatory focus of the Commission since the existence of a clear legal basis as to the settlement of (cross-border) securities transactions is a basic prerequisite for an efficient European internal market for financial services and the effective free movement of capital and payments (comprehensive information is to be found on the website of DG MARKT, Financial Markets Infrastructure). Following two reports by the so-called Giovannini Group, which identified 15 market hurdles (2001) and highlighted possible solutions (2003), the Commission adopted a communication on the way forward on the post-trade sector (COM (2004) 312 final). Consequently, the Commission convened several expert groups, viz the ‘Clearing and Settlement Advisory and Monitoring Expert Group’ (CESAME) looking into technology, market practices and governance, the ‘Clearing and Settlement Fiscal Compliance Expert Group’ (FISCO) analysing fiscal barriers, and the ‘Legal Certainty Group’ (LCG) preparing the harmonization of private law rules on intermediated securities. In addition, there are numerous working papers and recommendations of several international expert groups, eg the ‘Group of Thirty’ (G30), the ‘European Financial Markets Lawyers Group’ (EFMLG), the ‘European Central Securities Depositories Association’ (ECSDA), the ‘Committee of European Securities Regulators’ (CESR) and the ‘Committee on Payment and Settlement Systems’ (CPSS).
In August 2008, the Legal Certainty Group presented its detailed final report including legislative recommendations. Adopting a functional approach, only the legal effects of account credits are determined (ie book-entry securities, rec 4) rather than their conceptual nature (property right or trust). Book-entry securities are validly acquired vis-à-vis third parties (including the intermediary’s creditors but not necessarily the issuer) once credited to a securities account and disposed of by corresponding debit; acquisition in good faith is possible (recs 5–7). The report also contains recommendations regarding the possibility of a reversal of a credit or debit and the legal consequences thereof (recs 6f, 9). Furthermore, proposals concerning the mediated processing of corporate actions are also included (recs 12–14). Finally, issuers shall be able to choose any CSD within the EU to immobilize their issue (rec 15). Overall, the LCG’s recommendations are more detailed and aim at a higher degree of harmonization than UNIDROIT’s project (see 5. below). Based on the LCG report, the Commission is elaborating a securities law directive which is expected to be published in the second half of 2011 subsequent to public consultations which occurred in spring 2009 and December 2010, whereby the second consultation already referred to draft regulatory principles essentially implementing the LCG’s recommendations. The Draft Common Frame of Reference (DCFR) is somewhat ambiguous as regards book-entry securities: while the provisions on deposit (Art IV.C.-5:101(2)(c)) and on transfer of title (movable goods) (Art VII.-1:101(4)(a)) do not extent to securities, the rules on security rights in movable assets are explicitly applicable to intermediated holdings (Art IX.-1:201(7), (8)) (financial collateral).
5. Regulatory structures of uniform law
A global model on modern securities holdings has been elaborated under the auspices of UNIDROIT, ie the (Draft) Convention on Substantive Rules regarding Intermediated Securities adopted in Geneva in October 2009 (Geneva Securities Convention). The Convention does not aim at full harmonization but uses a functional approach to implement a compromise between legal certainty in cross-border cases and the preservation of national regulatory structures (‘internal soundness’). Inter alia, a securities credit gives rises to an insolvency-protected (Arts 14, 21) claim of the investor to the fruits attached to the underlying securities as well as the right to issue transfer orders (Art 9). Intermediated securities are acquired by credit and disposed of by debit (Art 11; on security interests financial collateral), good faith acquisition (acquisition of ownership from a non-owner) being possible (Art 18). However, the Convention leaves the question of the validity of a credit or the possibility of its reversal almost completely up to the applicable national law (Art 16) which undermines the intended legal certainty to a certain extent. The Convention similarly refers to the applicable law in numerous other provisions so that national law will continue to have considerable impact and therefore so will the rules on conflicts of laws.
6. Private international law
As to the private international law (PIL) of intermediated securities, both European and uniform law provide for special regimes (financial collateral).
Literature
Dorothee Einsele, Wertpapierrecht als Schuldrecht (1995); James Steven Rogers, ‘Policy Perspectives on Revised U.C.C. Article 8’ (1996) 43 UCLA Law Review 1431; Joanna Benjamin and Madeleine Yates, The Law of Global Custody (2nd edn, 2002); Frédéric Nizard, Les titres négociables (2003); Eva Micheler, Wertpapierrecht zwischen Schuldrecht und Sachenrecht (2004); Matthias Haentjens, Harmonisation of Securities Law, Custody and Transfer of Securities in European Private Law (2007); Philipp R Wood, Set-Off and Netting, Derivatives, Clearing Systems (2nd edn, 2007) paras 18-001 ff; Luc Thévenoz, ‘Intermediated Securities, Legal Risk, and the International Harmonisation of Commercial Law’ (2008) 13 Stanford Journal of Law, Business & Finance 384; Law Commission, The UNIDROIT Convention on Substantive Rules regarding Intermediated Securities, Further Updated Advice to HM Treasury (May 2008); Legal Certainty Group, Second Advice of the Legal Certainty Group: Solutions to Legal Barriers related to Post trading within the EU (August 2008); Hideki Kanda, Charles Mooney, Luc Thévenoz and Stéphane Béraud (eds), Draft Official Commentary on the draft Convention on Substantive Rules regarding Intermediated Securities (2009); Mathias Lehmann, Finanzinstrumente (2009); Matthias Haentjens, ‘Clearing, Settlement and Legal Infrastructure: Ways Forward’ [2011] Journal of International Banking Law and Regulation 243.
